Brian Gaynor: No one reining in the cowboys

There is growing opposition to the avalanche of rules and regulations being proposed for listed companies. Company directors are lobbying against the Stock Exchange's corporate governance guidelines and are criticising the Government's securities trading law review.

There is widespread sympathy for these concerns because New Zealand's main problem is enforcement, not regulation. There is little point in piling on more rules and regulations when inadequate enforcement is a far bigger problem.

The Securities Commission, which is the main enforcement agency, was established under Part 1 of the Securities Act 1978. Colin Patterson, the commission's first chairman, was a lawyer who placed a great deal of focus on law reform. His first priorities were to review the practices relating to nominee shareholdings, contributory mortgages and company takeovers.

The commission had limited enforcement powers under Part 1 of the act except "to keep under review practices relating to securities, and to comment thereon to any appropriate body". Just after the commission was established, Patterson wrote: "We have approached the exercise of this function cautiously, because we do recognise that persons who may be affected by our comments are entitled to put their point of view to us before we criticise them."

These comments indicated an overly cautious approach but the investment community, which was almost completely unregulated at the time, was extremely worried that Patterson would be an aggressive regulator. But stockbrokers and company directors needn't have worried; the commission was totally ineffective during the "Wild West days" of the 1980s.

There were a number of inquiries into sharemarket regulation and enforcement after the 1987 sharemarket crash.

In 1989 the Committee of Inquiry into the Sharemarket, called the Russell Report after its chairman, Sir Spencer Russell, recommended the establishment of a Supervisory Authority. This would oversee equity and retail debt markets and absorb the Securities Commission. It would also supervise self-regulatory organisations, which included the Stock Exchange.

The report recommended that the new Supervisory Authority be given full enforcement powers and be adequately funded. It also emphasised that the new authority needed to act quickly and decisively. Its members and executives needed a broader range of experience and skills than existing commission members.

In 1991 the National Government established a ministerial working group on securities law reform, called the Roach Report after chairman Brian Roach.

The report dismissed the criticism that New Zealand had a "Wild West" sharemarket. It argued that there had been a number of law reforms since the 1987 crash and the regulatory framework was adequate but enforcement was a major problem. According to the working group: "There is ongoing concern about enforcement of our securities law. Our review leads us to the conclusion that there are serious deficiencies in the enforcement of our laws. In our view this is the critical shortcoming in our regulatory environment."

THE working group believed that enforcement should be given the highest priority in the Government's securities law work programme. The Roach Report recommended that the country should continue to have a self-regulatory system and the removal of barriers to private enforcement (lack of information, uncompensated costs and legal complexity) was a top priority. This was in contrast to the Russell Committee, which supported the establishment of a strong enforcement agency with substantial powers and funding.

Meanwhile, the Stock Exchange, under chairman David Wale, was actively lobbying against new regulation and desperately trying to maintain its independence. As a partial response to the Russell Report the NZSE established the market surveillance panel on August 1, 1989 under chairman Norman Johnson.

The panel has been a failure, mainly because it has been extremely secretive and has not communicated with the investing public. It has granted far too many waivers and has made little attempt to explain the decisions.

The exchange has come to the same conclusion. It has decided to disband the panel and bring market enforcement inhouse. The exchange said that the "light-handed regulation" of the 1980s and 90s was no longer appropriate and under the new regime retrospective waivers would be considered only under unusual circumstances and all waivers and ruling decisions will be published.

The Takeovers Panel has set a great example for the exchange's new enforcement regime. The panel makes quick decisions and communicates these to the investing public.

The panel deserves top marks for its detailed report on the Infratil/Tranz Rail hearing held this week. The report, which is on the panel's website (www.takeovers.govt.nz), contains a summary of the submissions and the panel's analysis and determination.

New Zealand investors have been waiting a long, long time for an enforcement agency to produce this level of timeliness, communication and clarity.

The problem with security law enforcement is that we haven't made up our mind whether we want a self-regulatory regime, recommended by the Roach Report, or a central enforcement agency system proposed by the Russell Report.

A self-regulatory regime is one where individual investors are given the incentive and facilities to seek redress through the courts for any losses incurred through breaches of the rules.

OUR insider trading laws are based on self-regulation. Under this legislation investors are supposed to take the legal action to recover their losses, although the Securities Commission can assist (the commission is now able to take a case itself, following the law reforms introduced in December).

This self-regulatory regime has proved to be totally ineffective as no one has been prosecuted for insider trading since the regulations were introduced 15 years ago.

On the other hand, the enforcement agency role of the Takeovers Panel in relation to the Takeovers Code has been highly successful.

As the private enforcement regime has not been a success we have been gradually moving to an enforcement agency system.

In December, the Securities Commission was given added authority. It will be given more opportunities to act under the proposed insider trading regulations, although these rules will continue to have a self-regulatory feature.

But the commission does not have enough powers or financial resources to be an effective enforcement agency.

Its June 2003 year annual report, which was released this week, pointed out that the commission has no powers to act in relation to a misleading prospectus once the offer is closed (Vertex and Wakefield Hospital), has no ability to take actions for breaches of directors' duties and has no ability to prohibit individuals from acting as directors.

The commission is also hopelessly underfunded. It received only $4.1 million from the Government last year compared with A$161 million ($181 million) received by the Australian Securities and Investment Commission.

The enforcement of our securities regulation is a total mess because we are stranded half-way between a self-regulatory system that doesn't work and an enforcement agency regime that lacks authority and is totally underfunded.

The introduction of more and more rules and regulations is not the answer because these can have a negative impact on financial markets, for these reasons:

* They build up investors' expectations that are not fulfilled because of inadequate enforcement.

* Conscientious directors comply with the new rules but others do not and get away with it.

* Companies are discouraged from listing because of the huge number of rules.

The main priority of our rule-makers should be to establish a strong enforcement agency that is adequately funded. This is the only way to go because the self-regulatory system has not worked and most other countries have effective enforcement agency regimes.

It would be far better to have a small number of rules that are adequately enforced rather than a raft of regulations that many market participants disregard without fear of penalty.

* Email Brian Gaynor